IRS Changes Its Position on Performance-Based Compensation for $1 Million Compensation Limit

Under Sec. 162(m), a public company may not deduct
compensation paid to certain employees in excess of $1
million. However, compensation that qualifies as
performance-based compensation is not subject to the $1
million limit. In Rev. Rul. 2008-13, the IRS ruled that an
incentive plan is not performance-based compensation
because it allows payments upon involuntary termination
without cause by the employer, voluntary termination by
the employee with good reason, or voluntary retirement
regardless of whether the performance goals are met. Thus,
all payments under the plan are subject to the $1 million
limit, including payments made when the performance
criteria have been met.

According to the IRS, the
payment provisions run afoul of Regs. Sec.
1.162-27(e)(2)(v), which provides generally that
compensation is not performance based if an employee would
receive all or part of the compensation regardless of
whether the performance goal is attained. The regulation
makes specific exceptions to this general rule for
payments made upon death, disability, or a change in
control.

The revenue ruling and a recent similar
letter ruling (200804004) are a surprise to many employers
because they run contrary to two prior rulings (Letter
Rulings 199949014 and 200613012). In those rulings, the
IRS held that compensation was still performance based
even though the payments could be made upon involuntary
termination without cause or voluntary termination for
good reason.

Because many employers have adopted
compensation programs with provisions similar to those set
forth in the prior letter rulings, the holdings in the
revenue ruling will not apply to qualified
performance-based compensation for performance periods
beginning on or before January 1, 2009, or for
compensation paid pursuant to an employment contract as in
effect on February 21, 2008. (“Performance period” means
the period of service to which the performance goal
applicable to the compensation relates.)

Employers
who relied on the prior rulings will now need to change
their compensation programs on a prospective basis to
eliminate payments upon involuntary termination without
cause, voluntary termination for good reason, or voluntary
retirement or, if no changes are made to the compensation
program, reevaluate their tax position with respect to the
deductibility of the compensation. These employers will
also need to consider the impact of these tax positions on
their financial statements.

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”

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